Blowing Up The “Everything Bubble”

The flood of liquidity and ultra-accommodative monetary policies has simultaneously inflated multiple bubbles. Stocks, bonds, real estate, and speculative investments have all experienced historic inflations.

The byproduct of cheap debt and liquidity is the explosion of household net worth as a percentage of disposable personal income. Starting in the early 80s, as President Reagan deregulated the banking system, net worth exploded through massive leverage increases. Such was made possible by four decades of continually falling interest rates and inflation.

Another view is to look at the expansion of net worth relative to GDP growth. Of course, the massive deviation would not be possible without the massive increases in leverage over the last 40-years.

However, ironically, while it appears that Americans are far more wealthy, in reality, it is only a small fraction of the population that has benefitted. A point we made in “The Fed Made The Top 10% Richer.”

This framework is the basis for the rest of our discussion on the coming deflation of the “Everything Bubble.”

There is little argument that financial markets are currently in a “bubble.” The monthly chart of the S&P 500 shows the deviation from long-term monthly means at levels not seen since 1990.

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As discussed in “Yes, There Is A Stock Market Bubble,” valuations are just a reflection of the underlying psychology at the second-highest level in history. As noted:

“If market bubbles are about ‘psychology,’ as represented by investors’ herding behavior, then price and valuations are reflections of that psychology. In other words, bubbles can exist even at times when valuations and fundamentals might argue otherwise.”

During a “market mania,” investors must continue to rationalize overpaying for assets to keep prices moving higher. Over the last decade, the most common justification remains that low discount rates justify high valuations.

The problem comes when interest rates rise. Throughout history, an unexpected surge in interest rates has repeatedly led to poor investor outcomes.

Despite media rhetoric that “rising rates” aren’t a problem for the stock market, history suggests they are. Given the massive surge in corporate leverage promulgated by weak economic growth, higher rates will quickly impact corporate profitability and financing activities.

As history shows, such collisions have often left a trail of bodies in its wake.

Currently, there is also a “bubble” once again in housing as a continual suppression of borrowing costs, loose lending policies, and a flood of stimulus has led to a historical surge in home prices. As we noted previously in “There Is No Supply Shortage,” home price appreciation has once again eclipsed long-term price trends.

The current overvaluation in homes, of course, is driven by record-low mortgage rates.

However, as noted above, that economic support will quickly reverse as interest rates rise. Given there is a surging demand for homes, just as with the stock market, when rates rise, there will be a rush to sell to a diminishing pool of buyers.

Also, as with the stock market, owned by the top 20% of income earners, most houses bought were by that same fraction of the population. (Higher incomes and nearly perfect credit.)

Given the sharp rise in prices, the resulting price decline will likely be equally as quick.

Of course, there is nowhere more at risk from higher rates than the bond market itself. Given that “yield” is a function of price, there is a perfectly negative correlation between prices and interest rates.

I pointed out before the “pandemic-driven shut-down” the 2019 yield-curve inversion was signaling a problem with the bond market. To wit:

“The magnitude of the Fed’s response was also a function of “panic” based more on “recency bias” than facts. The Fed quickly returned to the “Financial Crisis” playbook to anticipate events that may occur in the credit markets rather than responding to outcomes.

There is a difference.

The Financial Crisis was a problem with the banking system. The COVID-19 pandemic is a health crisis.”

The Federal Reserve problem is they have now pushed “yield spreads” across the entirety of the credit spectrum to record lows. The Fed’s suppression of rates to “bail-out” the bond market in the short-term has created a long-term problem of “mispricing risk.”

That mispricing of risk, or rather the creation of “moral hazard,” in the credit markets created a record number of “zombie” companies in the process.